There are different types of marketplaces for executing securities transactions. Marketplaces include conventional stock exchanges, electronic exchanges, alternative trading systems, and reporting facilities. The marketplaces have different characteristics.
One type of marketplace is a conventional stock exchange that uses specialists to fill trade orders. The New York Stock Exchange (NYSE) is an example of a conventional stock exchange system that uses specialists. Specialists are members (of the exchange) who maintain an inventory of the securities for which they are designated specialists and stand ready to buy and sell shares of those securities as principals for their own accounts as necessary to satisfy their responsibility for maintaining orderly markets in those securities. Only one specialist can be designated for a given security, but members can be specialists for more than one security.
In the conventional stock exchange, trade orders are communicated to specialists face-to-face, by telephone, and by computer. Conventional stock exchanges are auction markets that have a physical exchange floor where buy and sell orders actually “meet” and orders are matched under the supervision of the specialist.
Another type of marketplace is an Over-the-Counter (OTC) electronic exchange that provides electronic access to posted market prices and does not use specialists or a floor-based exchange. The National Association of Securities Dealers Automated Quotation System (NASDAQ) is an example of this type of marketplace. Electronic exchange marketplaces like NASDAQ exist electronically, in the form of a communications system that constantly receives and reports prices at which geographically dispersed market makers are willing to buy and sell different financial instruments.
Market makers are similar to specialists and maintain firm bid and ask prices for securities in which they are making a market by standing ready, willing, and able to buy or sell those securities at publicly quoted prices. Market makers maintain continuous two-sided quotes (bid and ask). Market makers ensure that there is a buyer for a sell order and seller for a buy order. NASDAQ market makers place and match trade orders. Non-members of NASDAQ must place their orders and their customers' orders with a market maker who is a member of NASDAQ.
Once a market maker has entered a price, the market maker is obligated to either buy or sell at least a certain amount of securities at that price. After the market maker has either bought or sold those securities, it may then “leave the market” and enter a new bid or ask price.
In contrast to marketplaces that use specialists (e.g., the NYSE), there are usually multiple market makers in the NASDAQ market for a particular company's securities. Market makers create liquidity in the securities for which they are acting as market makers. To account for the effort and risk required to maintain liquidity, market makers are allowed to set the prices at which they are prepared to buy and sell a particular security and profit from the spread (i.e., the difference between the price which they purchased the financial instruments and the price for which they sell them).
For example, suppose a market maker has entered a sell order for a security and the bid/ask is $10.25/$10.30 per share. The market maker can try to sell the security at $10.30 per share. If it does, it can then enter a bid order to buy shares in the security and bid higher or lower than its previous bid of $10.25. If the market maker bids $10.26 and attracts a seller at the new price, it has successfully “made the spread.” If the market maker sold 1000 shares at $10.30 and bought 1000 shares back at $10.26, it made $40 (1000 shares×4 cents) on the difference between the two transactions. Making the spread repeatedly with large orders can result in lucrative profits. Because bid/ask prices can change rapidly, the time elapsed between transactions is often an important factor in determining whether a market maker can successfully make the spread.
NASDAQ makes real time market data available via a computer network at three different service levels, known as Level I, Level II, and Level III. Level I, for example, provides, among other things, real time access to market data that includes the highest bid and lowest offer for a security (i.e., inside market quotes), individual market maker quotations, and trade and price volume.
Another type of marketplace is an alternative trading system (ATS), which provides ATS members and electronic exchange users, such as NASDAQ users, access to an electronic network where they can display and fill their trade orders independent of a market maker or specialist. Electronic communication networks (ECNs), such as Instinet, Strike, and Island, are examples of ATSs. ECNs also make real time market data available.
In a conventional stock exchange or an electronic exchange, buyers and sellers make their trade orders through intermediaries, i.e., the specialist or the market maker dealing in the particular financial instrument. But with an ECN, there are no intermediaries, and each bid and offer is a discrete and anonymous order that all ECN members can access and view.
Marketplaces can also be described as primary marketplaces as distinguished from marketplaces that are reporting facilities. When a trade order is transmitted to a primary marketplace, an attempt is made to match the trade order with another trade order seeking the other side of the trade. Once trade orders are matched and the trade is executed, it must be then be reported in order to comply with certain regulatory requirements. Primary marketplaces may be any marketplace, such as the NYSE, the American Stock Exchange, NASDAQ, and ECNs, such as Instinet or Island.
With reporting facilities, there is no matching of a trade order with an order seeking the other side of the trade. When reporting facilities are used, the broker-dealer or dealer already has parties for both sides of a trade and needs only to document and report the clearing of the trade in order to comply with certain regulatory requirements. The NASDAQ Automated Confirmation Transaction (ACT) is an example of a reporting facility. The Cincinnati Stock Exchange is an example of a marketplace that can be used as a reporting facility. Reporting facilities, such as NASDAQ ACT, and marketplaces that can be used as reporting facilities, such as the Cincinnati Stock Exchange, provide faster access to market data than and increased trading efficiency over primary marketplaces.
Broker-dealers are individuals or firms that buy financial instruments for themselves and for others. When acting as a broker, a broker-dealer acts as an agent and facilitates filling orders on behalf of its customer. This is also referred to as an agency execution. The broker-dealer communicates directly with the various marketplaces where the trade orders are filled.
When acting as a dealer, the broker-dealer acts as a principal and trades for its own account. This is also known as proprietary trading or principal execution. When broker-dealers act as principals, they also communicate directly with marketplaces where trade orders are filled.
When acting as an agent for a customer, broker-dealers have a best execution obligation to seek to obtain the best available price for the customer's trade order. The National Best Bid and Offer (NBBO) is the best (the highest) bid price and best (the lowest) ask price currently available for a particular security at a particular time. The NBBO is obtained from real time market data available from different marketplaces registered to trade in a particular security, including electronic exchanges, such as NASDAQ, and ECNs, such as Instinet. The NBBO is continuously updated throughout the trading day and is made available to market makers, brokers, dealers, and broker-dealers.
A broker-dealer is not required to have a customer's trade order filled in any particular marketplace in fulfilling its obligation to seek to obtain the best available price for a customer's trade. It can route a customer's order to any outside marketplace that will provide the customer with the best available price. It should be noted that there could be more than one marketplace that can simultaneously provide the customer with a best available price that will satisfy the broker-dealer's best execution obligation.
A broker-dealer could also seek to internalize an order and fill an order itself by trading on its own behalf with a customer. But there are many customer orders that are not eligible for internalization because the broker-dealer could be perceived as unfairly taking advantage of the customer by internalizing the trade order. When acting as an agent for a customer, a broker-dealer cannot use information obtained from customers unfairly to profit from trading from trading with the customer from its own account. For example, when market makers obtained access to and were receiving customer orders before the markets opened, it raised concerns. The concerns were that market makers could use that information to determine market direction and strength and to profit from their own order flow when they traded for their own accounts once the markets opened.
A market order is an order to buy or sell a stock at the best price available at the time the order is filled. Market orders will generally be filled at or close to the NBBO. There are times, however, when trades will be filled at prices that are superior (higher than the highest bid or lower than the lowest ask) or inferior (lower than the highest bid or higher than the lowest ask) to the NBBO. Execution of a trade at a price that is superior to the NBBO is referred to as price improvement. Execution of a trade at a price that is inferior to the NBBO is referred to as price disimprovement.
A trade also can be executed with other types of improvement from the NBBO, such as size improvement and speed improvement. Size refers to the magnitude or number of shares of a trade offer or an executed trade. Size improvement refers to execution of a transaction in a magnitude or amount of shares that is greater than the amount of shares than the size quoted in the NBBO. Speed improvement refers to executing a trade faster than a trade quoted in the NBBO could be executed.
There are a variety of factors that can result in improvement or disimprovement from the NBBO that are related to the characteristics of the various marketplaces for transacting in financial instruments. For example, small differences in the speed at which a trade order is executed at a marketplace can cause price improvement or disimprovement because market prices can change significantly in a fraction of a second.
Different characteristics of different marketplaces can provide different advantages or disadvantages in speed of execution. For example, trading via a specialist provides several disadvantages. First, according to the April 2002 11Ac1-5 report, the average time it takes for a specialist on the NYSE to execute a single trade is approximately 20 seconds. During this 20-second long delay, the market price may move significantly and a trade order could be executed at a worse price than if it was executed in another marketplace during that 20 second delay. Second, according to the April 2002 11Ac1-5 report, on average, a specialist at the NYSE provides approximately a 0.55 cent improvement over the NBBO bid/offer price for orders between 100-499 shares, provides approximately a 0.1 cent disimprovement (i.e., a worse price) over the NBBO bid/offer price for orders between 500 and 1999 shares, and overall provides approximately a 0.49 cent disimprovement (i.e., a worse price) over the NBBO bid/offer price for orders between 1000-9999 shares.
By contrast, an electronic exchange or ECN provides much faster trade order execution than exchanges that use specialists. Although the average price from a specialist is generally worse than the NBBO price, there are times when an exchange that uses specialists will provide better prices than the electronic exchanges and ECNs.
There are other characteristics of particular marketplaces that relate to other factors that can result in price improvement and disimprovement. For example, there are some marketplaces that allow subpenny pricing (i.e., pricing of trades at down to the one-tenth of a penny level as opposed to down only to the penny level), while other marketplaces do not. The allowance of subpenny pricing in some marketplaces, but not others, is another factor that could contribute to price improvement or dismiprovement in certain market situations.
There are fully automated trading systems that reduce the latency period to execute a trade; however, these systems typically only offer the customer the actual NBBO bid/offer prices. Additionally, there are systems that provide modest price improvements above the NBBO bid/offer price; however, these systems are not fully automated. These systems also do not enable broker-dealers to internalize customer trade orders.
Accordingly, it is desirable to provide a method and a system for fully automating trade order processing that provides improvement (including price, size, and speed improvement) from the NBBO that is capable of being used for both agency and principal executions and for internalizing agency executions.